- CFTC Prevails in Challenge to Commodity Pool Operator Rules Affecting Registered Investment Companies
- July 1, 2013 | Authors: Abigail Bertumen; Ruoke Liu; Joshua B. Sterling
- Law Firms: Bingham McCutchen LLP - Washington Office ; Bingham McCutchen LLP - Boston Office ; Bingham McCutchen LLP - Washington Office
On June 25, 2013, the United States Court of Appeals for the District of Columbia Circuit affirmed the earlier decision of the United States District Court for the District of Columbia that granted summary judgment in favor of the CFTC in a challenge to the CFTC’s recent rule amendments affecting registered investment companies brought by the Investment Company Institute and the U.S. Chamber of Commerce. The rules at issue were amended CFTC Regulation 4.5, which provides registered investment companies with an exclusion from the definition of commodity pool operator (“CPO”), and new CFTC Regulation 4.27, which imposes a comprehensive set of reporting requirements on CPOs.
This Appeals Court’s decision will have important consequences for registered fund firms:
- Firms that have determined to register as CPOs with the CFTC in light of the amendments to Regulation 4.5 will be required to remain so registered.
- Firms that have been relying on the Regulation 4.5 exclusion will need to continue to comply with its requirements, including the recent amendments at issue in the case, which limit the permitted exposure to commodity interests (such as commodity futures and options and swaps) and restrict the manner in which a CPO can market a fund that trades commodity interests.
- A firm that is currently registered as a CPO or that will register as a CPO in the future will be required to comply with requirements imposed by the CFTC and the National Futures Association, the self-regulatory body for firms that trade commodity interests (the “NFA”).
In this last regard, firms should note that at least some of the CFTC’s requirements have yet to be “harmonized” with SEC requirements applicable to registered funds.1 The CFTC’s forthcoming harmonization release is widely expected to affect disclosure, recordkeeping, and reporting requirements with respect to registered investment companies that are commodity pools. Any firm registered as a CPO — which, for a registered fund, is typically the principal investment adviser — will face additional requirements with respect to its own activities and its personnel.
In February 2012, the CFTC amended Regulation 4.5 to limit the amount of exposure to commodity interests that a registered fund may have.2 In addition, the amended Regulation provides that a registered fund cannot be marketed to the public as a vehicle for trading commodity interests. The CFTC also adopted new Regulation 4.27, which requires registered CPOs to report certain information about counterparty relationships, investments, and other matters to the CFTC and other federal regulators on new Form CPO-PQR. However, the CFTC has indicated that registered funds subject to CPO registration — i.e., with investment advisers that must register as CPOs — will not be required to comply with Regulation 4.27 and other requirements under Part 4 of its regulations until 60 days after the harmonization proposal is finalized and effective.
On April 17, 2012, ICI and the Chamber filed a complaint in the District Court that challenged these rule changes. They argued that the CFTC failed to satisfy certain procedural requirements applicable to the agency under the Commodity Exchange Act (“CEA”) and the Administrative Procedure Act when it adopted the new rule and rule amendments. On December 12, 2012, the District Court issued an opinion granting the CFTC’s motion for summary judgment and upholding the amendments. ICI and the Chamber appealed the District Court’s decision and sought to reverse that decision. On May 6, 2013, the Court of Appeals heard oral argument in the case. (Please see our earlier alerts for a discussion of District Court’s decision and the May 2013 oral argument on appeal.)
As noted above, the Court of Appeals affirmed the District Court’s decision and granted summary judgment in favor of the CFTC.
The Appeals Court’s Opinion
In its opinion, the Court of Appeals addressed the following arguments made by ICI and the Chamber:
- Changes in Agency Position. The appellants argued that the CFTC failed to “explain why it changed from its more generous exemption requirements that had existed since 2003,” which contained no investment limits for registered funds claiming relief, “to the more stringent requirements” in amended Regulation 4.5. The appellants also argued that the CFTC acted arbitrarily and capriciously by not addressing the amended Regulation’s impact on liquidity, despite the fact that the 2003 version of Regulation 4.5 was “explicitly designed to promote liquidity in the commodities markets by making it easier for registered investment companies to participate in derivatives markets.”3 The Court responded to both arguments by stating that the CFTC need not demonstrate that “the reasons for the new policy are better than the reasons for the old one;” rather, it need only show that “the new policy is permissible under the statute, that there are good reasons for it, and that the agency believes it to be better.”4 The Court concluded that the CFTC had provided adequate detail in its rulemaking about the “changed circumstances” that prompted the agency to amend Regulation 4.5, including increased derivatives trading by investment companies, a perceived lack of market transparency that could lead to systemic risk, and a “congressional shift evidenced in the Dodd-Frank Act.”5
- Cost-Benefit Analysis. The appellants argued that the “CFTC failed to adequately consider the costs and benefits of the rule” as required by the CEA.6 Its consideration of these matters included the following notable points, which focused on the CFTC’s decision to finalize the amendment to Regulation 4.5 and to adopt Regulation 4.27 before finalizing the harmonization rules.
The appellants argued that, by adopting final regulations now and postponing the implementation of the harmonization rules, the CFTC “counted benefits that may not materialize and depend on the harmonization rule while ignoring costs that may result from the rule.”7 The Court responded that the “CFTC need not count costs” from regulations before they were finalized because the statute did not require it. As the Court explained, it would be “literally impossible to calculate costs from an unknown regulation,” and nothing prohibited the CFTC from “moving in an incremental manner.”8
The Court also rejected the argument that the CFTC improperly considered in its analysis hypothetical benefits from rules that had not been finalized, stating that the CFTC appropriately counted the benefits from the registration and disclosure requirements of Regulations 4.5 and 4.27. However, the Court stated in a footnote that “if it should materialize that harmonization in some fashion destroys those benefits, appellants would then be free to raise the resulting imbalance of costs and benefits in a challenge to the harmonization rule.”9
- Particular Aspects of the Amended Rule. The appellants contended that the CFTC’s amendments to Regulation 4.5 were arbitrary and capricious (and hence constituted an impermissible agency action) because they: (a) included swap transactions in the limitations on commodity interest investments; (b) restricted the definition of bona fide hedging, which provides a carve-out from commodity interest positions that count towards those limitations; and (c) failed to justify the five percent limit on initial margin for commodity interest positions held by a pool. The Court rejected these arguments. It noted that the Dodd-Frank Act had amended the definitions of “commodity pool” and “commodity pool operator” in the CEA to refer to swaps, which made it appropriate for the CFTC to include that category of instruments within the exclusion that Regulation 4.5 provides from CPO status. The Court also rejected the argument concerning the definition of “bona fide hedging,” noting that this argument amounted to “nothing more than another policy disagreement” with the agency.10 Regarding the final point, the Court decided to defer to the CFTC’s judgment concerning whether a five percent limit on initial margin for commodity interest positions was a proper threshold above which CPO registration would be triggered.
- Notice and Comment. The appellants argued that the CFTC failed to provide an adequate opportunity for notice and comment, both because the proposed rule’s cost-benefit discussion did not set out the basis for the final rule’s analysis and because the “CFTC did not give commenters notice of the seven-factor marketing test” to be applied to the marketing restriction under Regulation 4.5. The Court quickly rejected these points. It concluded that there had been adequate notice and discussion of costs and benefits, and that no notice and comment were required as to the seven factors because they were merely guidance and not part of the adopted amendments.11
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The decision by the Court of Appeals has the effect of leaving intact the CFTC’s new and amended regulations as they apply to registered fund firms. But the Court did note that the forthcoming harmonization release could be challenged on the basis of any deficiencies in the agency’s rulemaking process. It is certainly possible that those rules — which, as proposed, would affect registered funds in many significant respects — will be the subject of future litigation.
The harmonization release is widely expected to be adopted before the end of year, which means firms may soon face additional disclosure, recordkeeping, and reporting applicable to registered funds for which they have registered as CPOs. At the same time, those firms will be subject to regulation by the CFTC and the NFA, both of which have not had an active role in overseeing the registered funds industry in the past.
1 77 Fed. Reg. 11345 (Feb. 24, 2012).
2 See 77 Fed. Reg. 11252, 11258 (Feb. 24, 2012).
3 Investment Company Institute, et al. v. United States Commodity Futures Trading Commission, No. 12-5413 (D.C. Cir. June 25, 2013), Slip. Op. at 9-10.
4 Id. at 10.
5 Id. at 10-11.
6 Id. at 11.
7 Id. at 13.
8 Id. at 14.
9 Id. at 14-15.
10 Id. at 9, 16-19.
11 Id. at 19-20.